Which of the following is true of the simple two-sector economy (households and firms) used to explain the circular flow of income?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → There is no leakage from the system.
In this simple economy, households spend their whole income on goods made by the firms. So all income comes back to the firms, and there is no leakage.
Option (1) There is no leakage from the system. — Correct. Everything paid out as factor payments returns to firms as sales revenue.
Option (2) Households save a part of their income. — Incorrect. The model assumes that households do not save.
Option (3) Households pay taxes to the government. — Incorrect. There is no government in this economy, so there are no taxes.
Option (4) Factor payments by firms are more than the consumption expenditure of households. — Incorrect. Factor payments and consumption expenditure are equal, since nothing leaks out.
NCERT (2026-27): “2.2 Circular Flow of Income and Methods of Calculating National Income … The other channels of disposing their income are closed: we have assumed that the households do not save, they do not pay taxes to the government – since there is no government, and neither do they buy imported goods since there is no external trade in this simple economy. In other words, factors of production use their remunerations to buy the goods and services which they assisted in producing. The aggregate consumption by the households of the economy is equal to the aggregate expenditure on goods and services produced by the firms in the economy. The entire income of the economy, therefore, comes back to the producers in the form of sales revenue. There is no leakage from the system – there is no difference between the amount that the firms had distributed in the form of factor payments (which is the sum total of remunerations earned by the four factors of production) and the aggregate consumption expenditure that they receive as sales revenue. …” |